Seizing the Moment: Why Senior Loans Outshine Junk Bonds Now

And one of the best choices could be leveraged and senior loans.

These bonds could be in the so-called sweet spot when it comes to risk vs. reward, offering very high yields amid their placement in the bankruptcy ladder. In fact, investors may want to forgo old fashioned junk bonds for them.

Bonds are all about lending money. Senior and leveraged loans are no different. Essentially, senior and leveraged loans are loans made by banks to corporations. These loans are then packaged together and then sold to investors. Typically, senior loans are often issued to companies with credit ratings below investment-grade. This provides them with high starting yields above the rates of investment-grade corporate bonds.

Where it gets interesting for senior loans is their other features.

These loans often feature floating rate coupons/interest rates. Historically, they have been tied to LIBOR. But these days—and after the LIBOR fixing scandal—many banks use the Secured Overnight Financing Rate (SOFR) for their coupons. Every 30 to 90 days, the interest rate a bank collects from the loan will change. This means that senior and leveraged loans pay more when interest rates are higher and less when rates decline.

An additional feature comes from the ‘senior’ in their names.

These bonds often have higher placement on the bankruptcy ladder compared to other forms of debt. That’s because many of these loans are backed by an asset. Most of the time, a firm will take out a senior loan to purchase a physical asset such as a pipeline, expand a factory or invest in a new piece of equipment. However, in more modern times, senior loans are sometimes backed by accounts receivable or even intellectual property and patent portfolios.

This provides a level of safety if things go wrong. If a firm defaults, the bank and loan holders can essentially repo the pipeline, any office equipment, or property before it gets sold in a bankruptcy proceeding.

At their core, senior loans offer a higher level of safety than junk bonds with less risk.

The win for income seekers is that these bonds could be right in a proverbial sweet spot for portfolios.

Part of the reason comes down to the economy. Today’s mixed and directionless economic picture is actually great for senior loans. On the one hand, economic data still remains strong. This has helped keep default rates low and cash flowing at firms that have taken out debt. According to J.P. Morgan, coverage ratios and default rates for senior loan issuers are in-line with historical averages. This indicates that firms aren’t having trouble paying their debts.

At the same time, this strong economy has forced the Fed to keep benchmark interest rates at 5.5%. With inflation still riding strong, Fed cuts have been pushed further and further out on the schedule, with a good chance the Fed won’t cut at all this year. But the data isn’t so great the Fed will raise rates either.

With that in mind, senior loans are paying some very strong yields that should stay this high for a while. It’s a ‘goldilocks’ market environment so to speak.

The best part is that loans are offering better and higher yields than the junk bond market. According to alternatives and credit asset manager Pinebridge, the spread between loans and high yield bonds is currently at 180 basis points. The long-term average is about 85 bps. This chart shows the current spike and difference. ¹

Source: Pinebridge

This means investors are able to get a higher yield in loans versus junk bonds. And that yield is higher than it normally is.

This is interesting considering the higher credit quality of senior loans and the fact that they are backed by a physical asset. When a junk bond defaults, investors are thrown into the bankruptcy proceedings and wait their turn. This is not so with a senior loan.

Investors have taken notice. Leveraged funds have managed to realize more than 18 straight weeks’ worth of inflows, while they’ve managed to outperform junk as well. The average leveraged loan fund is up 2.7% this year, while the junk bonds have produced a 2%+ loss.

With leveraged loans now offering historically high yields amid a sweet market environment, investors looking to marginally increase their risk have an opportunity to score some big yields. The best part is that senior loans could be better than traditional junk debt when it comes to risk/reward.

Getting your hands on them has become much easier in the world of exchange-traded funds (ETFs). Like many asset classes, ETFs have opened up the world of senior loans with one ticker access. Beforehand, it was pretty much impossible to buy them and buying an individual remains incredibly hard. Often, they are bought and sold via private placements and over the OTCBB.

These funds were selected based on their exposure to senior and leveraged loans. They are sorted by their YTD total return, which ranges from 3.1% to 4.2%. They have expense ratios between 0.45% to 0.87% and assets under management between $123M to $7.2B. They are currently yielding between 5.3% and 9.6%.

Overall, leveraged and senior loans are an interesting fixed income asset class and, right now, they are shining. Thanks to the combination of a mixed market environment and steady high interest rates, they offer great yields. Those yields are enhanced by their credit quality and their placement in the bankruptcy ladder. For investors, the time to buy could be now.

With yields beating junk bonds and a better placement in the bankruptcy ladder, senior loans are a wonderful fixed income asset class for risk-seeking investors. The key is that those risks are lower than many investors believe and the market environment is in the sweet spot for continued returns.

¹ Pinebridge Investment (March 2024). Leveraged Finance Asset Allocation Insights: Bank Loans Have the Edge Over High Yield